Carlos Andres Rodriguez Herrera 1 30 23 Principles of Macroeconomics ECON 2002 01 Chapter 10 Real GDP and the Price Level in the Long Run Introduction Economic growth has trended steadily downward during the past four decades in nations with northern borders lying within the Arctic Circle such as Canada Russia and the United States Yet there is evidence to suggest that resources lying within the Arctic zone could employ to boost the economic growth rate of these countries In Chapter 10 we will look at how the overall performance of an economy is affected by the use of new resources Learning Objectives Understand the concept of long run aggregate supply Describe the effect of economic growth on the long run aggregate supply curve Explain why the aggregate demand curve slopes downward and list key factors that cause this curve to shift Discuss the meaning of long run equilibrium for the economy as a whole Evaluate why economic growth can cause deflation Evaluate likely reasons for persistent inflation in recent decades Chapter Outline Output Growth and the Long Run Aggregate Supply Curve Causes of Inflation Total Expenditures and Aggregate Demand The Aggregate Demand Curve Shifts in the Aggregate Demand Curve Long Run Equilibrium and the Price Level Output Growth and the Long Run Aggregate Supply Curve Aggregate Supply The total of all planned production for the economy Long Run Aggregate Supply Curve LRAS A vertical line representing the real output of goods and services after full adjustment has occurred It represents the real GDP of the economy under conditions of full employment the economy is on its production possibilities curve LRAS is vertical Input prices fully adjust to changes in output prices Suppliers have no incentive to increase output Unemployment is at the natural rate Determined by endowments and technology or existing resources Base year dollars The Ohio State University 1 The value of a current sum expressed in terms of prices in a base year Endowments The various resources in an economy including both physical resources and such resources as ingenuity and management skills Growth is shown by outward shifts of either the production possibilities curve or the LRAS curve cause by Growth of population and the labor force participation rate Capital accumulation Improvements in technology Total Expenditures and Aggregate Demand Aggregate Demand The total of all planned expenditure in the entire economy Questions What determines the total amount that individuals governments firms and foreigners want to spend What determines the equilibrium price level The Aggregate Demand Curve Aggregate Demand Curve AD A curve showing planned purchase rates for all final goods and services in the economy at various price levels all other things held constant What happens when the price level rises The real balance effect or wealth effect The interest rate effect The open economy effect The Real Balance Effect The change in expenditures resulting form a change in the real value of money balances when the price changes all other things held constant also called the wealth effect The Interest Rate Effect Higher price level indirectly increase the interest rate which in turn causes a reduction in borrowing and spending One of the reasons that the aggregate demand curve slopes downward The Open Economy Effect Higher price levels result in foreigners desiring to buy fewer American made goods while Americans desire more foreign made goods i e net exports fall Equivalent to a reduction in the amount of real goods and services purchased in the U S Aggregate Demand versus Demand for a Single Good or Service When the aggregate demand curve is derived we are looking at total planned expenditures on all goods and services i e the entire economic system When a demand curve is derived we are looking at a single good or service in one market only Shifts in the Aggregate Demand Curve Any non price level change that increases aggregate spending on domestic goods shifts AD to the right Any non price level change that decreases aggregate spending on domestic goods shifts AD to the left Carlos Andres Rodriguez Herrera 1 30 23 Changes That Cause an Increase in Aggregate Changes That Cause a Decrease in Aggregate Demand An increase in the amount of money in A decrease in the amount of money circulation Increased security jobs and future income Decreased security about jobs and future income Improvements in economic conditions in other Declines in economic conditions in other countries A reduction in real interest rates not due to price A rise in real interest rates not due to price level changes Tax increases Demand circulation countries level changes Tax decreases dollar A drop in the foreign exchange value of the A rise in the foreign exchange value of the dollar Long Run Equilibrium and the Price Level For the economy as a whole long run equilibrium occurs at the price level where the aggregate demand curve AD crosses the long run aggregate supply curve LRAS The effects of economic growth on the price level Economic growth and secular deflation Secular Deflation A persistent decline in prices resulting form economic growth in the presence of stable aggregate demand An increase in LRAS will ceteris paribus result in a decrease in the price level Avoiding secular deflation If the AD curve shifts outward by the same amount as the LRAS curve the price level remains constant a The AD curve can be shifted outward by increasing the money supply Supply Side Inflation Figure 10 8 panel a shows a rise in price level caused by a decline in long run aggregate supply A leftward shift could be caused by a Reductions in labor force participation b Higher marginal tax rates on wages Demand Side Inflation Figure 10 8 panel b a If aggregate demand increases for a given level of long run aggregate supply the price level must increase The Ohio State University 3 Summary Discussion of Learning Objectives Long run aggregate supply shift The long run aggregate supply curve is vertical at the level of real GDP that firms plan to produce when they have full information and when input prices have adjusted to any change in output prices Economic growth and the long run aggregate supply curve Shown by an outward shift of the LRAS curve or of the production possibilities curve Why the aggregate demand curve slopes downward and factors that cause it to Slopes downward due to the real balance effect the interest rate effect and the